A closer look at the VIX – what is it really telling us?
In these ‘harder’ times we are used to seeing the VIX move in large chunks. Some days we can see the VIX up or down as much as 10%. Most traders have come to understand the VIX as the ‘fear index’. Basically if the VIX goes up there is more fear in the market and likewise when it moves lower it means times are now calm.
Most traders also know that the VIX is a mean reverting device. That means it usually hovers around one general area and when it moves out of that area it will soon return. The VIX typically trades below 20 (calm).
So what is the VIX exactly?
The VIX was formed by the Chicago Board of Option Exchange (CBOE), and is based off of S&P 500 option prices for puts and calls spread over a wide variety of strikes. It is set to measure the expected 30-day implied volatility of the general market. Over time the CBOE have created many more volatility measures over a wider variety of markets.
The VIX is represented in percentage form over an expected annualized price change. So for example, if the VIX is currently at 20 that means the market expects a 20% move over the year. That is 5.77% change in the next 30-days.
VIX / SquareRoot(time) = Volatility for that period
20 / √(12) = 5.77%
To break that down to a daily basis (252 is the approximate days in a trading year):
20 / √(252) = 1.26%
In a normal market a 1% move in either direction is fairly normal. In fact most days will see less of a move than that in a clam market.
Now let’s look at a fearful market when the VIX is around 45. That is a 45% change in price over the year.
30 Day Basis:
45 / √(12) = 12.99%
On a daily basis:
45 / √(252) = 2.83%
Now a 2.83% a move every day is a bit farfetched. This is something that could happen from time to time but to see it every day would be something of a sight.
In the future when analyzing the VIX just remember that it means more than just a basic fear index.